Subscription financing makes it harder to assess return sources

The increased use of credit lines by private equity managers is making life harder for the limited partners and consultants that track the managers.

Sources said drawing out these lines of credit for longer periods and increasing the value of loans is bolstering internal rates of return by about 200 basis points, and more than 300 basis points in some cases. It means some managers are surpassing their carry hurdles, but the distortions are forcing consultants to look to other metrics in assessing firms.

David Fann, New York-based president and CEO of private equity consulting firm TorreyCove Capital Partners LLC, said executives at his firm have always used different analytical tools, but the "usage of these (financing lines has) made it difficult for a simple, straightforward apples-to-apples comparison of managers based on investment returns. Firms use these lines differently and some don't use them at all ... now, stripping out the effects of subscription lines is critical to manager assessment and benchmarking. Deconstructing investment performance is now more necessary than ever."

Andrew Brown, head of private equity manager research at Willis Towers Watson PLC in London, added: "Going forward we will benchmark IRR, but will definitely focus more on the multiples as a benchmark, with the IRR being less relevant. Some managers will use fund facilities for distributions too, so I think IRR as a benchmark ... goes out the window for less mature funds."

This "fund-level financial engineering" is a serious consideration for Cambridge Associates LLC, added Andrea Auerbach, a managing director and head of global private investment research in Menlo Park, Calif. "When our clients invest or we invest in a fund, we're not hiring the manager to employ fund-level financial engineering for the return, but to buy companies, improve their value and sell them at a gain. This level of noise at the top can obscure the true core talent of the manager because the underlying activity is masked."

But there are ways to "pierce through that fog," she said, citing guidelines from the Institutional Limited Partners Association, which include that GPs should publish returns on a leveraged and unleveraged basis.

ILPA's guidelines also were highlighted by Victor Quiroga, founding partner at Triago in New York. "They have really helped by creating a baseline for acceptable use of subscription lines. A significant departure from that baseline is what people are concerned about," he said.

Jennifer Choi, managing director at the ILPA in Washington, said in response to industry feedback on the guidelines the association is looking to make clearer their intended scope — that they are aimed at the use of subscription facilities where the primary intended purpose is short-term bridging and administrative smoothing for the benefit of both general and limited partners. Regarding the impact of credit lines on returns, more work is needed by the wider industry, she added.

Europe's private funds industry association also is mindful of the trend toward using credit lines, highlighting that the traditional use — to manage cash flows and avoid multiple capital calls — is a preference among long-term investors.

"At Invest Europe we regularly review our guidance to maintain the industry's high professional standards and promote alignment of interests. Our private equity manager and investor members are working together to agree how best to reflect and report current market practice in the next update of our Professional Standards Handbook," said a statement provided by a spokeswoman.

Cambridge's Ms. Auerbach also cited the use of the fund multiple in analysis. "If I see a 70% IRR and a 1.2 multiple, it's very clear to me there is a commitment facility being used, because those two numbers usually look in the same ballpark," she said. "If there is a big discrepancy from the typical, that is a signal to ask more questions."

But it's not a perfect metric. "The danger is that you can see a scenario, especially in the early days of the fund, where a top performer and worst performer difference could be 0.2, 0.3 on the multiple, and everything in between. So will we have to go another decimal point on a multiple benchmark?" Mr. Brown said.

Another way is to adopt a back to basics approach to investment investment-level benchmarking. "That is ripping the cover off the fund, going straight to the investments and seeing how they are doing," Ms. Auerbach added.

For those LPs that are benchmark-focused and want top-quartile private equity managers, it becomes difficult as private equity firms increase their credit facilities and durations in order to remain competitive. "You have to use something else," taking underlying portfolio drivers at the "micro level" into account, Mr. Brown said.

Triago's Mr. Quiroga said: "For those who are not used to this phenomenon, they need to ask for the right information. It's true that when you look at the publicly available information and databases, it's not always easy to tell which deals have deployed subscription lines."

It's not just the consultants asking for more information. "Most experienced LPs are aware of the risks. Also, many LPs are asking for greater transparency and disclosure on the use of subscription lines," said Mr. Fann.